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This paper addresses two assumptions in the debate on these Labor policies:

That pension members in large pooled funds (both industry and retail funds) will continue to receive the full benefit of their franking credits, especially when the fund has a large proportion of accumulation members.

That the reduction in the capital gains tax discount from 50% to 25% is not worthy of much attention.

1. Trustees have yet to decide how to treat franking credits

Retirees who believe pooled retail and industry super funds are a safe haven for their franking credits may have to rethink that strategy. The argument goes that large funds with a high proportion of members in the accumulation phase pay tax on their super contributions and earnings, and this will always create a sufficient tax liability to fully absorb the franking credits allocated to the fund.

And at a whole fund level, that is true. But for those fund members in pension phase who are currently credited with an earnings rate that reflects their nil tax status, Labor’s policy now becomes an issue.

Under strict super fund rules that insist all fund members be treated without bias, it is possible that fund trustees may decide they should not have franking credits allocated to their accounts because they have no tax due if Labor’s policy is adopted.

The fund’s equitable treatment of members provision may require pension members’ earnings to be adjusted down to reflect the loss of the use of their franking credits.

Let’s look at some illustrative numbers

Consider a hypothetical industry fund of size $140 billion, with approximately two million members in the accumulation phase and about 200,000 in the pension phase. The average account balance across the whole fund is therefore about $64,000. Let’s also assume an average pension account balance of $200,000 and an average accumulation account balance of $50,000. That would imply a total pension phase account balance of $40 billion and a total accumulation balance of $100 billion.

Assume the same asset allocation mix for both pension and accumulation accounts of say 50% fixed interest and 50% Australian equities. Assume also a 5.0% fully franked dividend yield on equities and a fixed interest yield of 5.0%. We also assume the superannuation guarantee 9.5% of an average salary of $60,000 per member in super contributions going into the accumulation fund, uniformly across the year.

Sparing the maths details, these assumptions would yield for the pension accounts $429 million in franking credits, nil tax and an earning rate of 6.1%.

And for the accumulation accounts, $1,123 million in franking credits with total tax due $2,665 million, consisting of $955 million tax on earnings and $1,710 million contributions tax, yielding an earning rate of 5.2%. And the earning rate across the whole fund would be 5.4%.

Total franking credits across all accounts is $1,552 million, which is significantly less than total tax due in the fund, and are therefore fully absorbed.

Under the Labor policy, the pension members have no tax to offset against and would lose the value of their franking credits, meaning the earning rate across the pension accounts would fall to 5.0% from 6.1%. Applying the principle of equitable treatment, 5.0% is the rate that should be credited to the pension fund accounts. That represents a sizeable 18% loss of earnings.

The earnings rate across the whole fund would be unchanged at 5.4% because the accumulation accounts are able to realise full value of the pension accounts’ franking credits as well as their own. But it is currently uncertain how the benefit that would arise at the expense of the retirees’ loss, would be dealt with.

The potential outcome for pension phase members

Pension phase members may be disadvantaged if the principle of fairness is applied to the fund. It has been suggested that some funds could opt to maintain the status quo and declare earnings rates assuming the pension accounts notionally realised the full value of their franking credits. But that would mean that accumulation accounts would in effect be cross-subsidising retirees by absorbing the pension accounts’ franking credits on their behalf. That may be considered unfair by some trustees. And remember, their actions are under increased scrutiny since the Financial Services Royal Commission.

This may adversely impact hundreds of thousands of Australians who thought they were shielded from Labor’s new policy. Retirees thinking of abandoning their SMSFs for large pooled funds should think again and at least wait until the position is clarified.

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2. Labor’s capital gains tax change is the sleeping giant

Labor’s proposal on capital gains tax has escaped detailed scrutiny since its announcement, perhaps because it is a one-off event, and tends to be long term by nature. The electorate usually has a short-term focus.

Labor’s policy is that the discount on the taxation of gains realised on assets held for longer than a year will be reduced from 50% to 25%. It will apply to all assets purchased after 1 January 2020 while investments made prior to that date will be fully grandfathered.

In 1999, the Howard Government replaced indexation of the capital cost base for inflation with a 50% discount on the capital gain if the asset was held for longer than a year. The discount became a proxy allowance for inflation, and is generous for assets held for short periods in a low inflation environment.

Get set for a double- or triple-whammy

As well as the reduced discount, Labor intends to maintain current stepped marginal tax rates indefinitely, meaning the one-off nature of capital gains potentially pushes investors into higher tax bands than otherwise would be the case.

Consider a wage earner on $50,000 who buys a property after Labor’s capital gains tax policy takes effect. He sells the property in the 2024/25 year realising a gain of $200,000. After the 25% discount the taxable gain is $150,000, and total taxable income is $200,000. The investor has been pushed from a marginal rate of 32.5% to 47%. With additional tax payable due to the capital gain, of approximately $60,000.

Compare with the same capital gain under the Coalition tax regime. A 50% discount would apply to the gain reducing the taxable gain to $100,000. And with a 30% marginal tax rate spanning income from $45,000 to $200,000 under the Coalition from 2024/25, the investor’s marginal rate does not change from 30%. The extra tax in respect of the gain therefore being $30,000. Just half of that under Labor.

And a high marginal tax rate not only increases the tax take. It can also have a distortion effect on the market, in affecting an investor’s propensity to realise capital gains or not. For example, a high marginal rate incentivises investors to realise losses in a falling market, exacerbating that market. While in a rising market, the investor will not want to realise the gain pushing the market even higher.

When we think of capital gains tax, we often think of property, but let’s not forget that it will apply equally to share investments. And this time under Labor, it is a triple whammy when investing in income-producing, growth equities. Not only is a middle-income investor hit with the non-refundability of excess franking credits when the investment is in the income-producing stage, she will also suffer the reduced capital gains discount and possible higher marginal tax rate when she eventually realises the gains.

The problem with a capital gain is that it is realised at a point in time, and taxed wholly as a lump sum, even though it has sometimes accrued over lengthy periods. In the year that the gain is realised, the capital gain can dwarf other income. It can have a sledgehammer effect.

In an ideal world the gain would be spread out and the taxation would be on an accrual basis annually, against which investment expenses could be offset. And in the case of negatively-geared investments, tax losses would be reduced by the unrealised gains, reducing the burden on the budget and weakening the argument for Labor’s negative gearing policy.

Whereas in the past, taxing capital gains on an accrual basis may have been difficult, it should be easier today using property indices. In the case of publicly-listed shares, valuations are available in the market.

Perhaps the real reform of capital gains tax needs to be considered before jumping straight to an arbitrary change in the discount rate.

Tony Dillon is a recently-retired actuary, with no affiliation with any political party. This article is general information based on a current understanding of Labor’s proposals. It should be read in the context of other arguments in articles such as this and this, where executives from large funds advise they expect to refund excess franking credits.

9 Responses to Two Labor policies facing inadequate scrutiny

With detail so sketchy, and legislation yet to pass the hurdles of a likely Independents-dependent Senate, the way forward is as clear as a fork in the road. That there are no definitive answers does not preclude the many questions – some you have highlighted.

Contrary to popular myth, the way a fund cascades earnings to members in different cohorts has always been the Achilles’heel of DC super, with sporadic unit pricing / crediting rate problems highlighting the risks to members and trustees. and Audit does not attempt to address it at all.

The proposed Labor franking policy will worsen it, but it has always been thus.

Instead of ASIC and APRA chasing trustees for inequitable treatment after the event, they should – once the details are known – clarify what would be in members’ best interests, for different cohorts. In other words, practise what they preach: improve their regulatory risk management!

Expect potential class actions, given the dollars involved.

Equity is not the preserve of accountants, actuaries or lawyers (even judges) but is in the mind of engaged consumers, and perfect equity is impossibly aspirational. If treated inequitably they will rollover,not roll over, or avoid voluntary super.

Tony your comments are provoking and interesting, however i believe you may be in error. I am a retired accountant and tax agent ( rt. 2004) and i admit I have not followed all changes since then, so my comments may be incorrect factually.
The property in the franking credits earned by the fund is the income pool belonging to all members in that pool and is not distributed to individual members as it would be in a unit trust. The individual members accounts are debited with their own tax liabilities in full and do not show any credits for the franking credit that has been offset against the payment tax of that tax.
Therefore the witholding of the benefit of the realisation of the franking credits from pension fund members of that pool would be an unfair treatment of them by the Trustees unless supported by legislation.
This may leave fund trustees open to a class action by pension members!

The ultimate decision that Super Fund trustees will make will depend on precise wording of the imputation credit legislation. Whether the imputation credit received by a Fund by virtue of the tax paid by contributing members can be applied to a non taxable retiree member will depend on how the legislation specifies to whom a rebate can be paid. If it states that non taxable investors (other than the specific exemptions for pensioners, charities, unions etc) are not entitled, Trustees will be in breach of that legislation if they then pay it to pension members.
In that situation, f I were a taxpaying contributor to a fund and found my imputation credits being shared with non taxpaying members I would be quick to bring an action against those Trustees.

franking credits: wouldn’t it be similarly ‘unfair’ if the accumulators got all the pensioners’ credits for free?

on the subject of CGT changes, i wasn’t aware from the media coverage that it applies to shares too – interestingly that ALP page linked to is all about housing affordability and doesn’t even mention the word ‘share’ but only ‘assets’. that is sneaky if they mean all assets, given the context of the page. it is also somewhat punitive since it is not taxing long term real gains but nominal ones.

Simon, I mentioned in the article that it is uncertain as to how the benefit arising from the pension accounts’ loss would be dealt with. I agree, it would seem unfair for the accumulation funds to benefit. Unfortunately policy detail is unclear. The issue of pooled funds becoming inequitable is probably just another unintended consequence of Labor’s policy, that needs resolution if the policy is implemented.

You raise interesting issues regarding perceived “fairness” under the (potential) new rules. Looking at the issue, as an accountant, I have a question.

These “pooled super funds” currently prepare a tax return where everybody’s income and credits mixed together. Since there is net tax payable, as you point out, they presumably will not be affected by the changes. In other words, the same amount of tax will be paid by the fund as before.

So my question is – how is the situation for these funds going to be any different to the current situation? Does the fairness issues that you raise already exist under the current arrangement?

Matthew, pension accounts in pooled super funds currently have full access to the value of any franking credits arising from their earnings, therefore there is no fairness issue under the existing arrangement. If the value of those franking credits are removed, then they are worthless to pension accounts and to be fair, their earnings should reflect that, even though the fund as a whole can absorb the franking credits.

Different tax exposure is already reflected in the earnings rates of pension and accumulation accounts that otherwise have the same asset allocation. Franking credits would just become another point of difference if they have value to certain accounts and not others.

Unfortunately detail in the Labor policy is sketchy. The SMSF ­Association has recognised that there are many unanswered questions regarding the policy, answers to which will not be fully know until when draft legislation is passed, should the policy ever be implemented.

“The Sunsuper fund generally receives a tax deduction for expenses we incur while we look after your account with us, and for insurance premiums. This is because the assessable income generated by the fund (including from taxable contributions) is more than the deductible expenses of the fund. The benefit of this tax deduction in respect of administration fees and insurance premiums is currently passed on by reducing the amount of any contributions tax payable, or via a tax benefit where there is no or insufficient contributions tax deducted.

From 1 July 2019, Sunsuper will no longer apply any tax benefit in excess of the amount of taxable contributions received. This means that the benefit of the tax deduction will not be passed on (or will not be passed on in full) to members with no or low taxable contributions.”

I wonder, then, whether this means that pension fund members will also not receive back franking credits refunds if there is a change in government and change of policy.